Hedge Funds With(out) Edge: A New Measure of Hedge Fund Manager Skill

Abstract

I introduce a new measure of hedge fund manager skill, Edge, that predicts hedge fund performance out-of-sample (OOS). In contrast to the standard approach that estimates skill based on an estimate of alpha, the Edge measure tells us how hedge fund managers produce alpha. A hedge fund manager has Edge if they produce positive alpha without being negatively affected by market downside risks. I document a new finding in the hedge fund literature: Hedge funds can be separated, ex-ante, into two groups, with respect to Edge. Only 3% of hedge funds possess Edge. OOS, hedge funds with (without) Edge have higher (lower) Sharpe Ratios and positive (negative) skewness. Hedge fund managers with Edge exhibit highly persistent performance, charge higher fees and run larger funds. I show the OOS performance of Edge is due to it’s robustness to an unidentified form of hedge fund model misspecification: weak latent factors.

Keywords: Hedge Funds, Skill, Edge, Weak Latent Factors, VIX Futures

JEL Classification: G11, G12, G14, G23